Germans discover it rains on the just too

So much for the strength of the euro. A month ago, we were preparing for the pound to hit parity against the single currency. It never happened and today it costs 87p to buy one euro - about halfway between parity and the rate travellers became used to in the good old days, 70p-ish. Against the dollar, the euro's surge during December now looks an aberration. One euro now buys $1.28, a fall from $1.44 at Christmas.

What happened? It's not a story of green shoots in the US or the UK. Jobless claims in the US have hit a 26-year high, while Citigroup and Bank of America have stumbled from one crisis to another. In the UK, output will shrink by 2.8% this year, the International Monetary Fund predicts; industrial production, we learned yesterday, fell even more steeply than thought at the end of 2008; and the state's stake in Royal Bank of Scotland is up to 70%.

No, the currency markets are saying that many of the newest, biggest worries come from the eurozone. Spain reported a 19.6% fall in industrial output in 2008, while Germany said the decline in industrial orders accelerated in December, taking the year-on-year fall to almost 40% - an extraordinary figure. Strength in manufacturing exports is not much help if trading partners can't afford to buy cars, machine tools and electrical goods. "Germany is going to go through a brute of a recession, almost certainly worse and longer than that of those unsound, debt-laden, floating-currency recidivists, the Anglo-Saxons," says Charles Dumas of Lombard Street Research.

It seems so unfair. Germany's prudence - remember its finance minister's jibes about Gordon Brown's "crass Keynesianism" - appears to have earned no reward at all. It avoided a housing bubble and concentrated on real, rather than financial, engineering and yet will feel the collapse in world trade more keenly than the spendthrifts in the US. In theory, Germany's healthy public and private finances make it well equipped to lead the eurozone out of recession. In practice, Germans show no inclination to go on a spending spree.

Germany is not the eurozone's biggest problem - Spain, Italy, Ireland, Portugal and Greece are. Italy may even top the list because of the size of its economy and the fact that it hasn't enjoyed the fruits of the boom - growth has averaged a little less than 1% since 2002, Italian industry is uncompetitive and public debt exceeds GDP. "Leaving the euro might be the only viable option to preclude total economic collapse," says Lombard Street.

Leave the euro? The idea is fanciful in one sense. Italy would hardly solve its problems by returning to the lira. Its cost of borrowing would balloon, probably overwhelming the boost to competitiveness from having a freely floating currency again. A more plausible plot may involve a debt default while staying within the euro - and that's another risk that financial markets have started to price in. The price of insurance against a sovereign debt default by Greece, Ireland, Spain and Italy has risen sharply.

The danger signals are not yet flashing red - government bond yields would still have to rise substantially before these countries struggle to finance themselves - but the market's view of the euro has shifted. Its safe-haven status provided stability to members during last year's banking dramas but a single currency is a poor tool to address internal trade imbalances. It makes sense for Germany to avoid flashy measures, such as a UK-style VAT cut: it is rich enough to be able to concentrate on longer-term structural improvements, such as investment in energy-saving technologies and industries. But that hardly helps the likes of Ireland or Spain, which are suffering the consequences of a UK-style housing bust.

Meanwhile, potential problems are brewing in the east as Russia's growth stalls. The big German and Italian banks are the biggest lenders to the emerging eastern European economies.

What if the European Central Bank were to change course? What if it were to embrace big monetary packages, such as expanding the money supply in the manner of the US and (probably) the UK? But operating such a policy within the eurozone's current framework would be tricky. Which country's corporate debt would the central bank buy? Whose government bonds would be first in the queue? The scope for political bickering would be enormous.

Of course, one can look at these issues from the other end of the telescope. If the US's free-spending approach doesn't achieve a revival, markets may once again punish the profligate, in which case sterling's mini-rebound would evaporate in no time. But, right now, investors prefer their policymakers to be radical and flexible. They look at the ECB, which on Thursday held interest rates at 2%, and see a central bank that is sleep-walking into trouble.